What is oil hedging

A Look at the Oil Market and Recent Developments

The main reason why the oil price took a nosedive last year was a fundamental change in oil market dynamics, as the US surpassed Saudi Arabia as the world’s largest oil producing country. This changing of the guard was largely due to the boom in the US shale oil industry, which the US has invested heavily in over the past few years. This development helped the US not only in becoming less reliant on foreign crude, but also contributed to an increase in (available) supply in the global oil market.

US oil field production and rig count.

The boom in the shale oil industry was made possible by an improvement in technology, which in turn reduced production costs in the industry. According to the US Energy Information Administration (EIA), the US was able to boost its daily production of crude oil to an average of 8.7 million bbl/d (barrels per day), up from around 5.6 million bbl/d back in 2008. Although oil production remains resilient thus far – partly due to the fact that many oil companies have hedged the oil price – the number of US oil drilling rigs has fallen sharply and has declined for 18 straight weeks to the lowest level since December 2010 (see chart above). However, as a result of the price plunge, the EIA is now less optimistic, expecting lower output from the shale oil industry starting in May.

The Organization of Petroleum Exporting Countries (OPEC) plays a decisive role in global oil markets and produces approximately 40% of total oil output. Due to its large market share, it is capable of influencing the price by changing the amount of oil it supplies. Although OPEC’s revenues have already dropped by 11% in 2014, they are now at 2010 levels and are expected to take an even stronger hit in 2015. OPEC is nevertheless insisting on maintaining production quotas and refusing to cut back on production to push the price upward. OPEC remains mum as to why it continues to maintain these output levels. However, it does seem likely that the aim is to preserve market share and weaken shale oil producers. Since OPEC countries have relatively low production costs, they are able to cope with extended periods of low oil prices better than their global competitors.

So, are there any other factors that contributed to the drop? Historically there appears to be a strong negative correlation between the price of oil and the US dollar. However, it wasn’t clear if this correlation was still valid, given the surge in US shale oil production. In light of what has transpired, it appears that this negative correlation between the oil price and the USD still holds true.

Another factor that may have played a role in the price decline is more speculative in nature and therefore much more difficult to verify. Could the price decline be an intentional move to hurt the Russian economy, which is highly dependent on income from energy exports? We should point out that crude oil represented about 33% of Russia’s export revenues in 2013, according to the EIA. This is significant, considering that about 50% of Russia’s federal budget revenue that same year was derived from mineral extraction taxes and export customs duties on oil and natural gas.

Oil consumption becomes more efficient.

Up until now we have concentrated on the supply side of the oil equation. What about demand? The IMF recently published its Gross Domestic Product (GDP) growth predictions in its World Economic Outlook (April 2015): World economic growth in 2015 is estimated to rise to 3.5% after the 3.4% growth rate recorded in 2014. This growth prediction is slightly better than it was 3 months ago. However, these growth rates are not high enough to have a noticeable effect on oil prices from the demand side, as was the case during the period of exceptionally strong growth during the period 2003-2007.

The normalization of global growth rates could also be seen as a reason for weakening global demand for oil, especially when coupled with an ever-increasing efficiency in energy usage. We came across an interesting chart (see chart above) that shows the decreasing relative importance of oil in the economy due to increasing energy usage efficiency. This long-term trend that will likely continue to impact future demand for oil.

Where is the Price Heading?

The EIA expects Brent crude oil prices to average $59/bbl in 2015 ($75/bbl in 2016). OPEC explains that the recent improvement in oil demand in Europe and Asia has played a part in the recent pick-up in the oil price. The EIA also expects that prices may pick up towards the end of the year to an average of $67/bbl in the fourth quarter.

While OPEC members have maintained they will not cut production, there is great uncertainty in the market due to the drop in oil drilling activity and shutting down of oil rigs, particularly in North America after shale oil production reached a record-high. The break-even points for shale companies vary strongly and many shale oil producers are already operating at a loss. The full impact of the drop in oil prices will be seen when the companies that have been hedging eventually have to cope with much lower oil prices. We believe that oil supply will remain relatively stable in coming years.

The demand side on the other hand depends strongly on the economy’s performance and the severity of the winter season. Emerging markets generated most of the demand growth in the oil market in recent years. Therefore, lower economic growth rates are likely to affect oil demand growth. It is

also worth mentioning that the shale oil boom has led to massive growth in oil storage and available storage is becoming increasingly rare, with the Strategic Reserve of the US Department of Energy operating at 95% of capacity and commercial storage at around 75%. We see similar developments in global storage capacities, which are likely to reduce the amount of demand that can be expected from storage facilities due to lack of capacity. It is therefore possible that we could see new lows in the oil price in the coming months.

Barring any unforeseen events, we expect that the oil price will stabilize at current levels and trade sideways for some time. In case of a positive boost to oil demand coming from a better-than expected economic environment, we may see a slight increase in oil prices. However, we find it unlikely that the price will go beyond $90 for the foreseeable future.

How are Countries Impacted by the Oil Price?

Clearly, the winners from the drop in the oil price are oil importers who are now benefiting from the lower oil expenses, even taking advantage of current price levels by storing up on oil before the price picks up again. Considering these importers, some are more obvious than others.

Major oil importers include China, Japan, India and most of the Western world. The World Bank previously estimated that every 10% of decline in oil prices will help boost the Chinese economy by 0.1-0.2%. If the World Bank’s calculation is correct, we can assume a 0.5%-1.0% boost to the Chinese economy due to the price decline of last year. India is another beneficiary. It is one of the largest oil consumers worldwide and dedicates about a third of its budget to energy subsidies. The decline will help save foreign currency reserves and will reduce its current account deficit.

Meanwhile, Japan, which has been suffering from a trade deficit for several quarters, will see less pressure on its energy bill, which has been particularly challenged since shutting down its nuclear reactors after Fukushima in 2011. The developed economies are also winners of low oil prices, but we’ll take a look at the impact on these countries in the next section.

On the losing side, we have Russia, the Gulf region, South American oil exporters and basically all other oil producers. Russia represented 15% of the world’s total oil supply in 2014, but it has been particularly squeezed by the drop in oil prices due to its poor economic performance, sanctions, and the political pressure in relation to the Ukraine crisis.

The Gulf region, and Saudi Arabia in particular, was not as severely affected by the drop in the oil price. Due to low production costs, these countries can still generate profits at current levels. However, they have huge social plans in place that are dependent on a higher oil price. If oil prices remain at these low levels for a prolonged period of time, the World Bank estimates the region will lose $215 billion p.a. in oil revenues, which represents more than 14% of its combined GDP. This will in turn affect the spending plans and investment strategies which they have been handling quite comfortably in times of higher oil prices. Saudi Arabia alone earned an estimated $246 billion in 2014, or about one-third of the OPEC cartel’s total export revenues. However, it seems keen on exporting heavily to maintain market share rather than cut production to support a higher oil price.

Saudi Arabia’s oil minister Ali bin Ibrahim Al-Naimi

Photo credit: Reuters

What Sectors are Expected to Gain?

Considering the impact on the economy, the drop in oil prices has raised deflation concerns. The collapse of the oil price led to a decline in the energy component of CPI and thus led to a reduction in inflation, moving it further way from the central bank target rate of 2%. We believe that this will give central banks more leeway to pump more money into the system.

With the oil price, and thus inflation, declining, consumers seem to be the biggest winners. Cheaper oil for transportation and heating increases consumers’ purchasing power and supports private demand in oil-importing countries. So if the consumer is the biggest winner from the oil price decline, which sectors do we expect to do well? In our view, consumer staples and retail companies will see a boost in sales as consumers have more disposable income available. With the increase in spending power, in conjunction with the strong dollar, companies exporting heavily to the United States stand to see a big boost in sales.

Manufacturing companies will benefit from lower transportation and packaging costs. The logistics and transportation sector will certainly benefit from lower energy bills and airlines will undoubtedly benefit as energy represents around 30% of their total operating costs. The mining and farming sectors stand to see a huge impact on their operating expenses. Energy represents about 30% to 40% of operating costs for mining, ranging from 40% to 50% in farming.

How can Investors Profit from the Oil Price Decline?

Timing the oil price for speculative purposes is extremely difficult. The volatility in oil prices, especially in the short- to medium-term, can be expected to stay high. Instead of investing directly in oil or oil companies, we would therefore prefer to invest in equities from the countries or sectors we highlighted here that are most likely to benefit from recent oil price developments.

This article is an excerpt from BFI Insights Q2 2015 which appeared on Mountain Vision ( http://www.mountainvision.com/en/home/ ), the portal from BFI Wealth Management ( http://www.bfiwealth.com/ ).